It is really nice to be writing about tax reform as it will be, not as it could be, or might be, or would be if they could get the votes, etc. After months and months of wrangling, there is a bomb of growth about to be dropped on the U.S. economy in the form of the new tax reform bill. As it is Christmas week, we will devote much of this week's column to unpacking the presents of this bill. There is a lot to know, and we hope you will put your investor stocking on and jump in with us.
How big of a deal is it?
Let's put it this way: the tax cuts out of 2018 alone represents $205 billion, over 1% of GDP. This makes it on a percentage of GDP basis the second largest tax cut in history (second to Reagan's world-changing tax bill of 1981). The Senate bill improved upon the stimulative nature of the House bill, and the final bill out of conference improved upon the stimulative nature of the Senate bill (many expected the bill to get worse in conference, not better). Obviously much of the benefit of this legislation has been priced into the stock market, evidenced by the significant add-on rally the market has seen in the last eight weeks. Our take? The markets are pricing in much of the benefit of earnings-per-share growth that the corporate tax cuts automatically create. BUT, the markets are not yet appreciating how much potential there is for real GDP growth embedded in this heavily supply-side reform legislation.
Well the CBO says...
The CBO forecasts that there will be 2.2% real GDP growth in the years ahead (1). In 2003, the actual GDP growth post-tax cut was 1.2% higher than projected, and in 2004 it was 1.3% higher. Put differently, they underestimated GDP impact (from a more modest tax cut) by $1 trillion over three years. But you know, what's a trillion dollars amongst bureaucrats with no skin in the game ...
Most attractive parts of tax reform for investors
With the tax bill now done, let's look at the good and bad of the new legislation as it pertains to investors and markets ...
- The 21% corporate tax rate (vs. present 35% rate) greatly enhances corporate profitability for many companies, creating more free cash flows, and greater opportunity for capital spending, growth initiatives, a more engaged labor force, stock buy
- backs, and dividend payments. This huge rate reduction is significantly supply-side and pro-growth. Regardless of what one company does with this increase to their own cash flow afforded them by reduced tax liability, it can only be better for investors than the current system - a distribution to the federal government.
- The 37% top rate vs. 39.6% top rate represents a 5% reduction on the margin for high-earners. This rate reduction is slightly supply-side, but more significant because it offsets the impact of lost deduction for state and local taxes.
- Immediate and full expensing for capital expenditures is a big, big deal. From small privately held companies and family businesses to large corporate conglomerates, the long-missing ingredient in GDP growth of growing capex is likely to be much addressed by this incentive (not to mention it remedies one of the most convoluted and complicated parts of the U.S. tax code)
- The movement to a territorial tax system which now avoids double taxation of U.S. companies with foreign profits is not only common sense legislation, but extremely important towards modernizing the code and incentivizing global competitiveness (2).
Least attractive parts of tax reform for investors
Are there disappointments for investors? A few things to consider ...
- The so-called ObamaCare surtax of 3.8% on investment income was not touched, leaving in a pretty punitive surcharge on investment income (marginally) for high earners many hoped would be dealt with in this process
- The repatriation tax rate (one-time tax hit in a "holiday" to get profits being held offshore moved back home) moved higher and higher throughout the process. Initially there was hope it would be 9%, which would be quite motivating for companies to take the hit (many have reserved against it) and move moneys back onshore. The final rate ended up being 15.5% for cash, and 8% for illiquid assets. This will be mandatory - meaning, companies will pay it whether they repatriate the cash or not. Most S&P 500 companies have already taken charges against this future liability (put reserves aside, essentially) larger than the liability, but the liability is much more burdensome than initially hoped.
- For future home purchases, the mortgage interest on up to 750k of debt will be deductible, vs. the $1 million level now. To be honest, I am really stretching to make this a negative, as I believe it will have no impact at all.
- This shouldn't be in the list, because higher bond yields driven by higher nominal growth are a GOOD thing, but certainly we expect interest rates to go higher in response to the GDP growth we expect this to create. And in theory that could be a negative for investors who have treated their real estate and bond investments as if interest rates cannot or will not ever go higher.
Does tax reform help municipal bond investors?
On the margin, it probably does. In the sense that the loss of state and local tax deduction most hurts high tax state residents, and in the sense that most municipal bond investors are in high tax states, there ought to be some marginal increase in the relative attractiveness of municipal bonds. But I have been doing this a long time, and have seen many changes in tax code that were to have a logical impact to municipal bond appeal. The consistent lesson markets have taught us on this subject is that demand is never as measurable around tax policy as one might suspect. It just isn't. It hasn't ever been. With that said, a few comments:
- The TOP income tax rate goes from 39.6% to 37% in this plan. While some would argue that makes the relative benefit of tax freeness for muni bonds lower, it is a non-event
- Corporations own some muni bonds, and their rate is going from 35% to 21%, so that is a more meaningful reduction in the relative attraction of muni bonds.
- But the cap of $10,000 for deductibility of state and local taxes makes muni bonds a lot more attractive for high earning savers in high tax states
- For municipal bond issuers, the new issues of advance-refunding bonds will no longer will be tax-exempt. This will impact how some issuers approach their own financing needs (3).
In theory, the worse thing that could happen for muni bond investors would be if the long-awaited mass migration of earners out of states like CA, NY, and NJ actually took place, led by fiscally unattractive cost of residency in those states, and leading to decreased financial resources to meet muni bond obligations. The remedy for this, of course, is better fiscal management of those states. We'll keep you posted (tongue firmly planted in cheek).
How much of a risk are interest rates here?
I am hesitant to point out the argument that my friends at Strategas Research make, which is that the 10-year bond yield went from 3.1% to 4.6% after President Bush's 2003 tax cut went through. I agree with the basic idea that this tax bill is highly stimulative, and greater GDP growth will drive bond yields up. However, the violence of that rate movement was clearly in a very different monetary environment, so needs to be understood in the present context. Conclusion: Rates are likely to move modestly higher, but not violently so, due to this tax reform bill. Bond portfolios should be positioned accordingly. Oh, and by the way, they should have been positioned accordingly even apart from this tax reform package!
Intensifying the Fed relevance of next year
The Fed has barely been a story in 2017 despite three interest rate hikes! 2018 is likely to change that. New personnel. A new chairman. And the potential of an economy actually running at full capacity. Central bankers will have work to do next year, and reporters will have work to do covering them. Our work will come from being heavily engaged in both the philosophical tendencies of the new regime, and what actions reflect that may be different than proposed ideas (if any such difference exists). Fed hawkishness is going to increase, we imagine, but how much remains to be seen.
Did somebody say capital structure?
The tax bill does provide modest incentive to utilize equity over debt in formation of capital structure. The limit of interest deductibility is a big part of that. I happen to think this is overthought, and will have little impact on 90% of the S&P 500. But in theory greater equity issuance could prove dilutive for some companies. My take? We might just be living in a period where a re-formation of capital structure towards lower debt and leverage and greater equity composition will prove to be stabilizing, not dilutive.
Passing by the pass-through section of the tax bill
Markets discussion of the new tax reform bill has almost entirely focused on public markets, because for the media the stock market takes center stage. But it is worth noting: So-called pass-through entities (s-corps, LLC's, partnerships, etc.) which have previously had their net income "pass through" to their owners' personal tax returns (pro rata) will also receive a sizable benefit in this new tax code. A 20% deduction of qualified business income will now be allowed (subject to limits and qualifiers) before passing through to those personal returns. Expect an avalanche of new LLC's etc.
China's Impact on 2018
When China looked like it may fall over in early 2016, global capital markets fell over. When China didn't fall over in 2016, markets rallied. 2017 saw significant acceleration in U.S. earnings combined with global reflation create an extraordinary investing environment. I do not expect China to fall out of bed in 2018, but I do maintain my view that if there is an ignored risk in capital markets right now, it is in China. There is no question their momentum has cooled, and credit growth there is necessarily slowing. But the industrial recovery there is real, nominal growth targets have been exceeded, and thus far financial deleveraging has been taken in stride.
We maintain our position that most of China (direct) is uninvestible for us, though our emerging markets managers may occasionally find particular bottom-up companies worth acquiring. But China does represent a significant bellwether on global economic conditions and sentiment in capital markets. It represents a heavy part of my weekly research digestion for that reason.
Chart of the Week
Essentially, the last time we saw pro-growth supply-side tax cuts was 2003. Real GDP growth (net of inflation) wasted little time spiking in response. Many circumstances are different and this tax bill is very different (more stimulative on business side; less so on individual side). But this historical framework warrants its place as our Chart of the Week.
Quote of the Week
"The most common investment mistake I have observed over a 40+ year career, is people believing an investment that has done very well is a good investment to now make, rather than a more expensive one."
~ Ray Dalio
It is really important that I emphasize the non-partisanship of my opinions on this tax bill. There are things I personally like and things I dislike in the package, from a political standpoint, yet I have not written about any of my personal political outlook here. My comments on the positive aspects of pro-growth incentives to drive capital to the U.S. and drive greater investment and production are said from a financial and economic standpoint objectively. The comments carry with them no more and no less by way of political commentary. I call it as I see it here, and what I see is a tax bill likely to greatly enhance American competitive advantage in a challenging era of global economic reality.